Friday, March 27, 2009

Shakespeare knew how financial crises worked

Full credit to this one for Nate Oman - BRILLIANT.

To read it in its original format:http://www.concurringopinions.com/archives/2009/03/the_bard_of_the.html

Over the weekend, I re-read A Merchant of Venice, and I was struck by the fact that Shakespeare manages to include in the play virtually every element of the current financial crisis. Scene one begins with a discussion of risk assessment, and Antonio's belief that he has managed to tame the vagaries of commercial fate through diversification. Asked by Salarino if he "Is sad to think upon his merchandise" (I.i.40), Antonio responds:

Believe me, no. I thank my fortune for itMy ventures are not in one bottom trusted,Nor to one place; nor is my whole estateUpon the fortune of this present year.Therefore my merchandise makes me not sad. (I.i.41-45)

Having ignored the problem of fat tails and black swans, Antonio decides to engage in a bit of dodgy finance. He borrows in the wholesale market from Shylock under terms that appear favorable, but have a huge downside in the unlikely event of his default. Antonio, of course, is unconcerned. From his point of view he is getting cheap money by taking on what seems like an extremely remote risk. He then takes these borrowed funds and uses them to make what can only be described as a no doc, subprime loan. Bassiano wants money for a speculative venture -- the wooing "In Belmont [of] a lady richly left" (I.i.161) -- and Antonio agrees, in effect renting out his credit rating:

Try what my credit in Venice can do;That shall be racked even to the uttermostTo furnish thee to Belmont to fair Portia.Go presently inquire, and so will I,Where money is; and I no question makeTo have it of my trust or for my sake. (I.i.180-185)

Shylock, for his part, does not approve of the loose monetary policy in Venice, which he rightly blames on wild lending practices, such as Antonio's loans:

How like a fawning publican he looks.I hate him for he is a Christian;But more, for what is low simplicity,He lends out money gratis and brings downThe rate of usance here with us in Venice. (I.iii.38-42)

Faced with such low returns on normal loans, Shylock is forced into the shadowy world of loan-to-own, in this case targeting, as he tells Antonio, "...an equal pound/ Of your fair flesh, to be cut off and taken/ In what part of your body pleaseth me" (I.iii.147-149). As he later reveals, Shylock is engaged in a bit of arbitrage in the commodity markets and wants Antonio's flesh "To bait fish withal" (III.i.49).

When all Antonio's "argossies" reportedly wreck at the same time -- a wildly improbable event predicted by none of Antonio's complex statistical models and, as we have seen, completely discounted by him -- his over-leveraged balance sheet sends him spinning into bankruptcy and ruin. For his part, after Lorenzo makes off Madoff-like with Shylock's daughter and his savings -- "A diamond gone cost me two thousand ducats in Frankfurt!" (III.i.77-78) -- he is left to lament (albeit in prose):

Why thou loss upon loss! The thief gonewith so much, and so much to find the thief, and nosatisfaction, no revenge, nor no ill luck stirring butwhat lights o' my shoulders, no sighs but o' my breath-ing, no tears but 'o my shedding. (III.i.85-89)

Of course, once his ill-fated bet on Bassiano and the power of risk management starts to unwind, Antonio's surrogates begin lobbying the government to change the rules so as to avoid unwanted contracts. To his credit, the Duke resists these entreaties, because, as Antonio acknowledges:

The duke cannot deny the course of law;For the commodity that strangers haveWith us in Venice, if it be denied,Will much impeach the justice of the state,Since that the trade and profit of the cityConsisteth of all nations. . . . (III.iii.26-31)

His laudable concern for the commercial reputation of Venice, however, does not prevent the Duke from using the bully pulpit in an attempt to brow-beat Shylock into renegotiating his contract with Antonio:

Shylock, the world thinks, and I think so too,That thou but leadest this fashion of they maliceTo the last hour of act; and then 'tis thoughtThou'lt show thy mercy and remorse more strangeThat is they strange apparent cruelty'And where thou now exacts the penalty,Which is a pound of this poor merchant's flesh,Thou wilt not only loose the forfeiture,But touched with human gentleness and love,Forgive a moiety of the principal,Glancing an eye of pity on his losses,That have of late so huddled on his back,Enow to press a royal merchant downAnd pluck commiseration of his stateFrom brassy bosoms and rough hearts of flint,From stubborn Turks and Tartars never trainedTo offices of tender courtesy.We all expect a gentle answer, Jew. (IV.i.16-34)

The Duke's speech, of course, falls into the standard rhetorical tropes from the perennial battle between Main Street and Wall Street, finance and the "real economy." Shylock is asked to forgive the principal out of "human gentleness and love" and Antonio's unfortunate losses "huddled on his back," nevermind, of course, that it was Antonio who got himself into the problem with the first place through irrational exuberance and shoddy lending practices. Of course, beneath the velvet appeal to mercy and solidarity there is the steel fist of an unstated threat. Shylock is "Jew," the member of a hated minority and the memory of young men following him through the streets taunting him over the loss of his daughter just a few scenes before must be fresh in his memory. The duke is willing to stand behind the "justice of the state," but for how long in the face of an increasingly belligerent public that his sided decisively with Antonio?

Of course, the story is resolved when deus ex machina Portia arrives with clever legal arguments that allow Antonio to escape his obligations while giving the city a fig leaf behind which it can hide its ultimately thin commitment to contractual sanctity. (Of course, realist that I am, in the end I think that that it is Portia's rhetoric -- "The quality of mercy is not strained..." (IV.i.182) -- rather than her legal analysis that does the real work.) The ending, however, requires the forced conversion of Shylock and what amounts to public control of his capital through a series of strong-arm negotiations rather than outright legislation.

Needless to say, finance and capitalism will never be the same in Venice again. With Antonio and his friends in control, I shudder for the prospects of efficient capital allocation in the future. I think that we can expect more loans to well-connected folks like Bassanio with questionable business models.